Liquidity rules have lagged because of a lack of precedent and because they need to build upon and “complement” other rules like capital regs. That’s according to Federal Reserve Governor Daniel Tarullo, who also said the prudential supervisors were on the look-out for liquidity rules’ unintended consequences.
And indeed many big banks have too, cautioning against overly burdensome rules, and warning that implementing liquidity controls can be more fraught with unforeseen issues than other issues. For instance, they are far harder to apply than capital rules, according to many observers.
“Measures to regulate liquidity have by-and-large lagged other regulatory reforms, for at least two reasons,” Governor Tarullo said in remarks to the Clearing House 2014 Annual Conference. “First, prior to the crisis there was very little use of quantitative liquidity regulation and thus little experience on which to draw,” Gov. Tarullo said in prepared remarks. “While the Basel Committee got to work quickly, senior central bankers and heads of bank supervisory agencies extended the timeline for implementation of liquidity standards to guard against unanticipated, undesirable consequences from these innovative regulatory efforts.”
Governor Tarullo said in formulating liquidity rules, supervisors have been considering many things, including the possibility of banks hoarding funds during times of stress, which would further freeze up markets. They also considered the impact of, say, extending the liquidity coverage ratio rule to a year (vs. the current 30-day stress period), and whether it would lead to “the kind of excessive self-insurance that would lead to undesirably reduced maturity transformation and financial intermediation.”
As for hoarding, efforts to deal with it will be more art than science, Governor Tarullo appeared to imply. Companies, he said, would hoard out of fear they would “project weakness to counterparties, investors, and market analysts. Instead, they should hold what liquidity is needed and if they fall beneath the limits, they can expect the Fed to be gentle. In other words, firms should feel free to use what liquidity in times of stress without the Fed breathing down their neck. “We may be more successful in enforcing the maintenance of liquid asset buffers in normal times for use in stress periods than we will be in encouraging their use when such a stress period arrives,” Gov. Tarullo said.
“For this reason we are working on a supervisory approach in which the remedy for falling below regulatory thresholds is context dependent,” Gov. Tarullo said in his remarks.
Gov. Tarullo also said the Fed would continue discouraging reliance on short-term wholesale funding, reiterating previous comments that the higher the amount of short-term funding held by large banks, the bigger the high-quality liquid asset buffer needed under the LCR requirements must be. The bigger the buffer, the bigger the cost, Gov. Tarullo said.
The Fed Governor ended his remarks by saying that there could be an extension of the rules beyond regulated financial institutions. The Financial Stability Board, he said, was looking at extending “the framework to cover transactions among unregulated entities.” This he hoped would prevent a migration of cash and the run risks to the shadow banking system. “We will need to monitor developments in order to assess whether further action is needed to consolidate the progress we have made in promoting financial stability,” he said.